Issue #2, November 2001

The Mouse that Roared: Oberweis Micro-Cap Fund

By Richard Hefter, Editor, The SmallCap Manager

Up 13.3% for the year through November 14, and ranked in the top 1% of its category by Morningstar, the Oberweis Micro-Cap Fund has seen its assets double in the last month from $17 million to $34 million as investors have poured money into a winner. What’s its secret? The whole under-loved micro-cap asset class for one, says fund manager Jim Oberweis, Jr., plus a fairly straightforward strategy that combines value and growth in identifying mice that roar.

What do you like about Micro Caps?

Micro caps being a different asset class which we define as companies with under $150 million in market cap tend to have returns that are distinct from other asset classes. So from the traditional perspective of diversifying among asset classes with somewhat uncorrelated returns, having micro caps as part of a person’s portfolio makes an awful lot of sense.

But there’s more to it than just diversification. Historically, it’s our belief that micro-cap stocks have done better than any other sector of the stock market over very long periods of time. The famous Ibbotson studies show that to be the case. So we focus on micro-cap stocks because we think that small companies have a greater ability to grow. A very small company with a unique or dynamic product would have an easier time doubling in size than, say, a billion or two billion dollar company.

But they can be riskier.

There are certainly constraints and drawbacks in that a smaller company also has a greater probability of running into financial difficulties and maintaining a constant growth level. You tend to have less experienced management teams.

But interestingly we have found that the volatility in the micro-cap names actually tends to be less than that of the companies in our Mid-Cap Fund.

Why is that?

I guess because there’s less institutional ownership of these types of companies. So they tend to be owned by individuals rather than institutions, and institutions tend to act in the herd, which drives the price of stocks up and down very quickly.

In a year of value, how have you been able to do so well in a growth fund?

In general you’re right, it’s been a value year, but you have to go back and remember in 1999-2000, when the mid caps and large caps were really roaring it was not a good time for micro-cap names. In 1999, our Micro-Cap Fund was up 19% while our Mid-Cap Fund was up 113% using the exact same investment strategy. Clearly there was a focus on mid-cap stocks then and micro-cap stocks were very much unloved.

I think what you’re seeing now is simply is a response by investors to some spectacular bargains. And as the market has come down, people are starting to look at earnings and valuations and trying to find where the best deals are in the marketplace, and micro-cap stocks really fit that bill quite well.

What’s distinct about your strategy?

We focus on profitable companies. We only buy companies that are making money. We’re looking for companies with rapid increases in both sales and earnings -- a minimum growth rate of 30%. So these are truly dynamic companies. And we also pay a lot of attention to valuations. We don’t buy companies unless we can find them at a P/E not greater than one-half of their growth rate

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Why?

If we were going to go out and buy a company, we would certainly look at how fast we thought we could grow that company in relation to what we were going to pay for it. Valuation is extremely important. There are certainly great companies that are bad investments because the price we are paying for those companies are just very poor. So keeping a valuation perspective, we’re able to sort through a whole database of rapidly growing companies and pick out the best bargains.

What are some companies you like?

One area where we found a lot of interest is in some of the specialty pharmaceutical companies like Bradley Pharmaceuticals (BPRX). It’s only at about a $100 million market cap right now. Bradley has been very successful in acquiring drugs from some of the major pharmaceutical companies -- their secondary and tertiary tier drugs that aren’t of real importance to some of the larger companies. They were able to grow sales last year at a 30-plus percent rate that’s led it to be one of our largest positions in the Micro-Cap Fund. The stock has gone from about $2 ½ to about $12. So that’s been a great name for us.

On the retail side we like Famous Dave’s of America (DAVE). It’s a retail restaurant that operates warehouse-style barbecue restaurants. Again it’s been a solid story and has appreciated from about $3 ½ to a price of $7 and change currently.

Are there stocks you like that haven’t run up yet?

Sure, but just to be clear, we tend to buy after there’s been some price appreciation. For example, one we just recently acquired is a company called MIM Corp. (MIMS). If you pulled a graph on that you’d see in the past year the stock has gone from about $1 to $11. Those kinds of run-ups don’t necessarily mean the stock is expensive, because what you’ve also seen is a commensurate growth rate in corporate earnings for the company. We think that if the company is able to earn 50 cents and 75 cents next year, a price of $11 is probably fairly inexpensive given their growth rate of over 50% in sales in the last quarter.

In general, it’s usually a mistake on these to sell too quickly. For the most part, if a small company is able to be that successful that the market is driving up the price of the stock, you’re better off just holding on and going for the ride. Especially because what tends to happen more often than not in these small high-growth stocks is that earnings come in higher than expected as well. None of these stocks actually have a high P/E ratio in our opinion relative to future 12-month earnings estimates.

What other stocks interest you?

In the beer distribution business, Central European Distribution Corporation (CEDC) out of Sarasota, Florida has been very successful at importing beer, wine and spirits to Poland. The company is actually the largest distributor of alcohol in Poland, and it continues to be one of our favorite buy ideas even if they’re at highly appreciated levels right now.

Another name that’s been a long-time holding in our Micro-Cap Fund is Gentner Communications (GTNR). Gentner makes video and audio conference systems. Particularly in the wake of September 11, this area is expected to grow at even a faster rate than was already assumed. Gentner’s been able to grow at about a 30% rate for the past several years, and we think that the outcome of the terrorist activities will probably slightly increase that. That’s not the only reason to be buying the stock, but it’s a nice bonus.

What’s your outlook for the micro-cap sector?

We think this sector is in a great position for the next several years and we also think in the long run micro-cap stocks are likely to do better than most other sectors of the stock market.

We’re entering an environment that has historically been very good for small-cap and micro-cap names, that being a period of low interest rates. A period of decline in interest rates tends to favor small companies much more than large companies. An article put out by Prudential stated that in eight of the last 11 periods of declining interest rates, small-cap stocks substantially outperformed large-cap stocks for the following 12 months after the first rate cut.

In addition, as you come out of a recession small-cap stocks have historically done very well. For older investors who lived through the second half of the 70s, they know a lot about small-cap stocks because that was just a spectacular period for investors in smaller companies. The returns on those types of companies approximately doubled the returns of the S&P 500 from 1975-80. So tremendous outperformance came out of that 1973-74 bear market. If you look at the most recent recession in the 1990-91 area, you saw the same thing. As we came out of that recession, small-cap stocks really outperformed.

So I really think that micro-cap stocks benefit right now from a combination of great valuations, low interest rate policy and the potential for a nice recovery once we come out of the recession with small-cap growth names leading the market.